PART I – FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

 

KONA GRILL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

KONA GRILL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

KONA GRILL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

KONA GRILL, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

 

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included in Item 1 of Part I of this Form 10-Q and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2017 contained in our 2017 Annual Report on Form 10-K.

 

Certain information included in this discussion contains forward-looking statements that involve known and unknown risks and uncertainties, such as statements relating to our future economic performance, plans and objectives for future operations, expectations, intentions and other financial items that are based on our beliefs as well as assumptions made by and information currently available to us. Factors that could cause actual events or results to differ materially from those indicated by these forward-looking statements may include the matters under Item 1A, “Risk Factors” in this report, our Annual Report on Form 10-K for the year ended December 31, 2017 and other reports filed from time to time with the SEC.

 

Overview

 

We currently own and operate 45 restaurants located in 22 states and Puerto Rico. Over the past four years, we have grown organically through opening new restaurants and doubled the number of domestic restaurants during this time from 23 to 45. Our unit growth rate was 22% in 2016, with eight openings during the year and we had 23% unit growth rate in 2015 with seven restaurant openings. We opened one restaurant in 2017. We believe that a modest growth rate over the next few years, primarily through franchising, will allow us to focus our time and attention on restaurant operations and improving financial performance. To assist with these efforts, we hired Jim Kuhn as our Chief Operating Officer, in December 2017. During the first half of 2018, restaurant operating profit improved $1.3 million or 13.7% while Adjusted EBITDA improved $2.3 million or 106% compared to the first half of 2017.

 

We continue to execute our strategy for international market expansion through franchised restaurants. As there is increased demand for upscale casual dining concepts overseas, we believe there is a significant opportunity to expand our concept in several international markets. In 2016, we signed an agreement for the development of six Kona Grill restaurants in the United Arab Emirates. In April 2017, we signed an agreement for the development of one Kona Grill restaurant in Vaughan, Canada. The agreement allows our franchisee the right to develop additional restaurants in the Toronto market for a specified period of time following the opening of the first restaurant. Our international franchise partners in the UAE and Canada opened a Kona Grill restaurant in their respective countries in the second half of 2017. Additionally, we completed a private placement in May 2018 with a large investor who intends to become our master franchisee in China. We are also in discussions with other potential partners to franchise the Kona Grill brand in other countries.

 

During the second quarter of 2018, we terminated the development and franchise agreements with our franchise partner in Mexico as a result of the franchisee ceasing to do business at the franchised restaurant. The termination of the development agreement and the franchise agreement is immediate and without prejudice to any of the Company’s rights and remedies as franchisor to obtain damages or other remedies against the developer, franchisee, and franchisee’s guarantor. As a result, we recognized $0.3 million of revenue associated with the remaining deferred upfront territory and franchise related fees during the three months ended June 30, 2018.

 

Additionally, we have filed franchise registration statements in the U.S. in certain states where required to expand the Kona Grill brand domestically through franchising. Similar to many other restaurant companies, we intend to utilize a dual strategy of both company-owned and franchised restaurants, which allows for the expansion of the brand in more markets throughout the U.S. Under the franchise model, we will provide training and operational support to our partners without committing or putting at risk capital for restaurant construction.

 

 

Cost of sales, labor, and other operating expenses for our restaurants open at least 18 months generally trend consistently with revenue, and we analyze those costs as a percentage of revenue. Our typical new restaurants experience gradually increasing unit volumes as customers discover our concept and we generate market awareness. We anticipate that our new restaurants will take up to twelve months to achieve the majority of operating efficiencies as a result of challenges typically associated with opening and operating new restaurants, including lack of market recognition and the need to hire and sufficiently train employees, as well as other factors. We expect cost of sales and labor expenses as a percentage of revenue to be higher when we open a new restaurant, but to decrease as a percentage of revenue as the restaurant matures and as the restaurant management and employees become more efficient in operating that unit. Occupancy and a portion of restaurant operating expenses are fixed. As a result, the volume and timing of newly opened restaurants has had, and is expected to continue to have, an impact on cost of sales, labor, occupancy, and restaurant operating expenses measured as a percentage of revenue, which we expect will continue until these restaurants mature.

 

Key Measures We Use to Evaluate Our Company

 

Same-Store Sales Percentage Change. Same-store sales percentage change reflects the periodic change in restaurant sales for the comparable restaurant base. In calculating the percentage change in same-store sales, we include a restaurant in the comparable restaurant base after it has been in operation for more than 18 months. We adjust the sales included in the same-store sales calculation for restaurant closures, primarily as a result of remodels, so that the periods will be comparable. Same-store sales growth can be generated by an increase in customer traffic counts or by increases in the per person average check amount. Menu price changes and the mix of menu items sold can affect the per person average check amount.

 

Sales per Square Foot. Sales per square foot is a measure of a restaurant’s productivity and represents the amount of sales generated for each square foot.

 

Average Unit Volume. Average unit volume represents the average restaurant sales for the comparable restaurant base.

 

Restaurant Operating Profit. Restaurant operating profit is defined as revenue minus cost of sales, labor, occupancy, and restaurant operating expenses. Restaurant operating profit does not include general and administrative expenses, depreciation and amortization, or preopening expenses. We believe restaurant operating profit is an important component of financial results because it is a widely-used metric within the restaurant industry to evaluate restaurant-level productivity, efficiency, and performance prior to application of corporate overhead. We use restaurant operating profit as a percentage of revenue as a key metric to evaluate our restaurants’ financial performance compared with our competitors. This measure provides useful information regarding our financial condition and results of operations and allows investors to assess future financial results driven by growth and to compare restaurant level profitability.

 

EBITDA and Adjusted EBITDA. EBITDA is defined as net income (loss) plus the sum of interest, taxes, depreciation and amortization. Adjusted EBITDA is defined as EBITDA plus unusual or non-recurring items, such as impairment, lease termination and exit costs and write-off of deferred financing costs. EBITDA and Adjusted EBITDA are presented because: (i) we believe it is a useful measure for investors to assess the operating performance of our business; (ii) we believe that investors will find these measures useful in assessing our ability to service or incur indebtedness; and (iii) we use EBITDA and Adjusted EBITDA internally as a benchmark to evaluate our operating performance and compare our performance to that of our competitors. EBITDA and Adjusted EBITDA as presented in this report are supplemental measures of our performance that are neither required by, nor presented in accordance with, GAAP. EBITDA and Adjusted EBITDA are not measurements of our financial performance under GAAP and should not be considered as alternatives to net income, operating income, or any other performance measures derived in accordance with GAAP, or as alternatives to cash flow from operating activities as a measure of our liquidity.

 

 

Financial Performance Overview

 

The following table sets forth certain information regarding our financial performance for the three and six months ended June 30, 2018 and 2017:

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2018				2017				2018				2017
Revenue percentage change			(9.9	)%			8.5	%			(8.5	)%			11.7	%
Same-store sales percentage change			(12.1	)%			(5.3	)%			(10.3	)%			(4.8	)%
Average unit volume (in thousands)		$	924			$	1,108			$	1,851			$	2,166
Sales per square foot (in thousands)		$	128			$	154			$	256			$	300
Restaurant operating profit (in thousands)		$	6,075			$	5,144			$	11,060			$	9,728
Restaurant operating profit as a percentage of revenue			14.3	%			10.9	%			13.1	%			10.6	%
EBITDA (in thousands)		$	2,996			$	(257	)		$	4,474			$	359
EBITDA as a percentage of revenue			7.1	%			(0.5	)%			5.3	%			0.4	%
Adjusted EBITDA (in thousands)		$	3,044			$	1,599			$	4,559			$	2,215
Adjusted EBITDA as a percentage of revenue			7.2	%			3.4	%			5.4	%			2.4	%

 

 

The table below sets forth a reconciliation of Net Loss to EBITDA, Adjusted EBITDA and restaurant operating profit to the most comparable U.S. GAAP measure.

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2018				2017				2018				2017
(In thousands)
Net loss		$	(1,000	)		$	(4,327	)		$	(3,460	)		$	(7,700	)
Income tax expense (benefit)			13				25				(15	)			50
Interest expense, net			624				408				1,228				714
Depreciation and amortization			3,359				3,637				6,721				7,295
EBITDA		$	2,996			$	(257	)		$	4,474			$	359
Lease termination and exit costs(1)			48				1,384				48				1,384
Write-off of deferred financing costs			—				472				37				472
Adjusted EBITDA		$	3,044			$	1,599			$	4,559			$	2,215
General and administrative			3,154				3,084				6,624				6,716
Preopening expense			—				461				—				797
Gain on insurance recoveries(1)			(123	)			—				(123	)			—
Restaurant operating profit		$	6,075			$	5,144			$	11,060			$	9,728

 

 

(1)     Amounts are included in “Lease termination costs and other” in the accompanying unaudited Condensed Consolidated Statements of Operations.

 

 

		Percentage of Revenue								Percentage of Revenue
		Three Months Ended June 30,								Six Months Ended June 30,
		2018				2017				2018				2017
Net loss			(2.4	)%			(9.2	)%			(4.1	)%			(8.4	)%
Income tax expense (benefit)			0.0				0.1				0.0				0.1
Interest expense, net			1.5				0.9				1.5				0.8
Depreciation and amortization			7.9				7.7				8.0				7.9
EBITDA			7.1				(0.5	)			5.3				0.4
Lease termination and exit costs			0.1				2.9				0.1				1.5
Write-off of deferred financing costs			—				1.0				0.0				0.5
Adjusted EBITDA			7.2				3.4				5.4				2.4
General and administrative			7.4				6.6				7.9				7.3
Preopening expense			—				1.0				—				0.9
Gain on insurance recoveries			(0.3	)			—				(0.1	)			—
Restaurant operating profit			14.3	%			10.9	%			13.1	%			10.6	%

 

Certain amounts may not sum due to rounding.

 

Results of Operations

 

The following table sets forth, for the periods indicated, the percentage of revenue of certain items in our financial statements:

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2018				2017				2018				2017
Revenue			100	%			100	%			100	%			100	%
Costs and expenses:
Cost of sales			25.3				27.7				25.5				27.7
Labor			35.4				36.4				36.0				36.7
Occupancy			9.9				8.9				10.0				9.0
Restaurant operating expenses			15.0				16.0				15.4				16.1
General and administrative			7.4				6.6				7.9				7.3
Preopening expenses			0.0				1.0				0.0				0.9
Depreciation and amortization			7.9				7.7				8.0				7.9
Lease termination and exit costs			(0.2	)			2.9				(0.1	)			1.5
Total costs and expenses			100.9				107.3				102.6				107.0
Loss from operations			(0.9	)			(7.3	)			(2.6	)			(7.0	)
Write-off of deferred financing costs			0.0				1.0				0.0				0.5
Interest expense, net			1.5				0.9				1.5				0.8
Loss before income taxes			(2.3	)			(9.2	)			(4.1	)			(8.3	)
Income tax (expense) benefit			0.0				0.1				0.0				0.1
Net loss		$	(2.4	)%			(9.2	)%		$	(4.1	)%		$	(8.4	)%

 

Certain amounts may not sum due to rounding.

 

 

Three Months Ended June 30, 2018 Compared with Three Months Ended June 30, 2017

 

Revenue. Revenue decreased $4.6 million, or 9.9%, to $42.3 million during the second quarter of 2018 from $47.0 million in the second quarter of 2017. Our same-store sales decreased 12.1% year over year, driven primarily by a decrease in customer traffic compared to the prior year period as a result of our reduction in happy hour times and store hours for certain of our restaurants. This reduction in operating hours and changes in happy hour times/offerings is part of the Company’s strategic initiatives to drive overall profitability.

 

Cost of Sales. Cost of sales decreased $2.3 million, or 17.5% to $10.7 million in the second quarter of 2018 compared to $13.0 million in the same prior year period with the decrease primarily attributable to our continued efforts on enhancing recipes and streamlining processes to improve margins as part of the Company’s cost-savings initiatives. As a percentage of revenue, cost of sales decreased to 25.3% for the second quarter of 2018 compared to 27.7% in the prior year quarter, due to strategic purchasing initiatives and an overall favorable commodities environment compared to the same prior year period.

 

Labor. Labor costs decreased $2.1 million, or 12.4%, to $15.0 million year over year compared to $17.1 million during the prior year same quarter as a result of our continued efforts and emphasis on wage management. Labor expenses as a percentage of revenue decreased to 35.4% compared to 36.4% in the prior year period, primarily attributable to an overall increase in labor efficiencies, including our continued efforts on recipe and process enhancements and the strategic changes to operations.

 

Occupancy. Occupancy expenses remained flat at $4.2 million in the second quarter of 2018 and 2017 respectively. No new locations have opened since the second quarter of 2017. Occupancy expenses as a percentage of revenue increased to 9.9% in the second quarter of 2018 compared to 8.9% in the second quarter of 2017, attributable to an overall lower sales volume.

 

Restaurant Operating Expenses. Restaurant operating expenses decreased $1.2 million, or 15.5%, to $6.4 million in the second quarter of 2018 compared to $7.5 million in the same prior year period. The decrease is primarily attributable to a decrease in advertising expenses, travel and relocation costs and variable operating expenses as a result of the lower sales volume. Restaurant operating expenses as a percentage of revenue were 15.0% and 16.0% in the second quarter of 2018 and 2017, respectively.

 

General and Administrative. General and administrative expenses were $3.2 million and $3.1 million for the second quarter of 2018 and 2017, respectively. The $0.1 million increase in absolute dollars was primarily attributable to the overall increase in legal related costs associated with outstanding litigation efforts. This increase is partially offset by a decrease in labor and benefits, including stock-based compensation expense as a result of headcount reductions made during the fourth quarter of 2017 as part of the Company’s cost-savings initiatives. As a percentage of revenue, general and administrative expenses were 7.4% and 6.6% during the second quarter of 2018 and 2017, respectively.

 

Preopening Expenses. We did not record any preopening related expenses during the second quarter of 2018. Preopening expenses were $0.5 million in the second quarter of 2017, attributable to the Scottsdale restaurant which opened in June of 2017.

 

Depreciation and Amortization. Depreciation and amortization expense decreased $0.3 million or 7.6% to $3.4 million year over year. Depreciation and amortization expense as a percentage of revenue was 7.9% and 7.7% of revenues in the second quarter of 2018 and 2017, respectively. The decrease was primarily attributable to the impact of fully depreciated assets during the quarter and the decrease in certain long-lived assets as a result of the $9.3 million impairment charge recorded in the fourth quarter of 2017.

 

Lease Termination Costs and Other. In the second quarter of 2017, we assessed our capital allocation strategy and made the decision to not move forward with the planned construction and opening of a restaurant. As such, we recognized $1.4 million related to estimated lease termination costs and asset write-offs during the three months ended June 30, 2017. However, during the second quarter of 2018, we entered into a settlement agreement regarding the termination of that specific lease agreement for $0.6 million, and as such recorded a $0.4 million adjustment in the three months ended June 30, 2018.

 

 

Additionally, during the second quarter of 2018, we decided not to pursue opening a restaurant for which we had a signed lease and entered into a lease termination agreement with the landlord for $0.2 million. As such, we recorded a $0.2 million lease termination accrual, as well as a $0.2 million asset impairment charge associated with this particular lease agreement.

 

Lastly, we recorded a gain on insurance recoveries of approximately $0.1 million during the second quarter of 2018 for business interruption and property damage claims for two of our restaurants that experienced hurricane and flood damage.

 

Interest Expense, Net. Net interest expense, consisting primarily of interest expense on borrowings, deferred loan fee amortization and line of credit commitment fees, was $0.6 million in the second quarter of 2018 compared to $0.4 million in the second quarter of 2017.  Net interest expense in the second quarter of 2018 includes interest expense on $33.7 million in borrowings under the credit line compared to $37.2 million in borrowings in the prior year period.  The increase in interest expense compared to the prior year is due to an increase in interest rates as a result of increases in LIBOR over the past 12 months as well as higher loan rates as a result of the fourth amendment to the credit facility that was entered into during March 2018.

 

Write-Off of Deferred Financing Costs. Effective June 30, 2017 we amended our Credit Facility to provide additional flexibility with financial covenants and also decreased our Revolver from $45 million to $30 million and shortened the maturity date to October 12, 2019. As a result, we wrote-off a portion of the unamortized deferred financing costs associated with the Amendment of approximately $0.5 million during the three months ended June 30, 2017.

 

Income Tax Expense. Income tax expense was $13,000 and $25,000 during the second quarter of 2018 and 2017, respectively, related to state income tax expenses for which no state net operating loss carryforwards or other credits exist.

 

Six Months Ended June 30, 2018 Compared with Six Months Ended June 30, 2017

 

Revenue. Revenues decreased 8.5% to $84.4 million during the first half of 2018 from $92.2 million in the first half of 2017. Same store sales decreased 10.3% in the first half of 2018 compared to a decrease of 4.8% in the first half of 2017 driven primarily by a decrease in customer traffic compared to the prior year period as a result of our reduction in happy hour times and store hours for certain of our restaurants. This reduction in operating hours and changes in happy hour times/offerings is part of the Company’s strategic initiatives to drive overall profitability.

 

Cost of Sales. Cost of sales decreased $4.0 million, or 15.7% to $21.5 million during the first half of 2018 compared to $25.5 million during the same period in the prior year, with the decrease primarily attributable to an overall lower sales volume and lower costs on certain items compared to prior year period. As a percentage of revenue, cost of sales was 25.5% compared to 27.7% during the same prior year period, primarily reflecting a favorable commodities environment and our continued efforts on enhancing recipes and processes to improve margins.

 

Labor. Labor costs in the first half of 2018 decreased $3.0 million, or 10.2% to $30.4 million compared to $33.8 million in the comparable prior year period, mainly due our continued efforts and emphasis on wage management and recipe and process enhancements. Labor expenses as a percentage of revenue decreased to 36.0% compared to 36.7% in the prior year period.

 

Occupancy. Occupancy expenses increased $0.1 million or 1.8% to $8.4 million in the first half of 2018 compared to $8.3 million in the prior year period. The increase is attributable to our Scottsdale Quarter location which opened in the second quarter of 2017 and contributed $0.2 million, of base rent and common area maintenance charges to the total increase. Occupancy expenses as a percentage of revenue were 10.0% in the first half of 2018 compared to 9.0% in the first half of 2017.

 

 

Restaurant Operating Expenses. Restaurant operating expenses decreased $1.9 million, or 12.5%, to $13.0 million during the first half of 2018 compared to $14.8 million in the same period in 2017. The decrease is primarily attributable to a decrease in advertising expenses, travel and relocation costs and professional services, partially offset by an increase in delivery services fees and repair and maintenance related activity. Restaurant operating expenses as a percentage of revenue were 15.4% during the first half of 2018 compared to 16.1% in the first half of 2017.

 

General and Administrative. General and administrative expenses decreased by $0.1 million, or 1.4% to $6.6 million from $6.7 million year over year. However, general and administrative expenses as a percentage of revenue increased to 7.9% in the first half of 2018 compared to 7.3% in the prior year period as a result of an overall lower sales volume. The $0.1 million decrease in absolute dollars was attributable to the overall decrease in labor and benefits, including stock-based compensation expense as a result of headcount reductions made during the fourth quarter of 2017 as part of the Company’s cost-savings initiatives. This decrease is partially offset by an increase in corporate office rent as a result of the Corporate office move in May 2017 and an increase in audit and legal related fees.

 

Preopening Expenses. Preopening expenses in year to date 2017 were primarily attributable to the Scottsdale Quarter restaurant, which opened in June of 2017. No new restaurants have opened since June 2017.

 

Depreciation and Amortization. Depreciation and amortization expense decreased $0.6 million or 7.9% to $6.7 million year over year, primarily attributable to the impact of fully depreciated assets during the quarter and the decrease in certain long-lived assets as a result of the $9.3 million impairment charge recorded in the fourth quarter of 2017. However, depreciation and amortization expense increased as a percentage of revenues to 8.0% in the first half of 2018 compared to 7.9% in the prior year period as a result of an overall lower sales volume.

 

Lease Termination Costs and Other. In the second quarter of 2017, we assessed our capital allocation strategy and made the decision to not move forward with the planned construction and opening of a restaurant. As such, we recognized $1.4 million related to estimated lease termination costs and asset write-offs during the three months ended June 30, 2017. However, during the second quarter of 2018, we entered into a settlement agreement regarding the termination of this specific lease agreement for $0.6 million, and as such recorded a $0.4 million adjustment during the six months ended June 30, 2018.

 

Additionally, during the first half of 2018, we decided not to pursue opening a restaurant for which we had a signed lease and entered into a lease termination agreement with the landlord for $0.2 million. As such, we recorded a $0.2 million lease termination accrual, as well as a $0.2 million impairment of fixed assets associated with this particular lease agreement.

 

Lastly, we recorded a gain on insurance recoveries of approximately $0.1 million during the second quarter of 2018 for business interruption and property damage claims for two of our restaurants that experienced hurricane and flood damage.

 

Interest Expense, Net. Net interest expense, consisting primarily of interest expense on borrowings, deferred loan fee amortization and line of credit commitment fees, was $1.2 million in the first half of 2018 compared to $0.7 million in the first half of 2017. Net interest expense increased the first half of 2018 as a result of the overall increase in the interest rate environment compared to the prior year period. We also capitalized approximately $96,000 of interest during the first half of 2017 as interest was incurred to fund new restaurant construction. We did not capitalize any interest expense during the first half of 2018.

 

 

Write-Off of Deferred Financing Costs. During the first half of 2017 we amended our credit facility to provide additional flexibility with financial covenants and also decreased our Revolver from $45 million to $30 million and shortened the maturity date to October 12, 2019. As a result, we wrote-off a portion of the unamortized deferred financing costs associated with the Amendment of approximately $0.5 million during the six months ended June 30, 2017.

 

Subsequently, during the first half of 2018 we amended our credit facility to provide additional flexibility with financial covenants and also decreased our Revolver from $30 million to $25 million and further reduces the available credit on the Revolver to $22.5 million at June 30, 2018 and $20 million at December 31, 2018. Additionally, the Amendment extended the maturity date to January 12, 2020. As a result, we wrote-off a portion of the unamortized deferred financing costs associated with the Amendment of approximately $37,000 during the six months ended June 30, 2018.

 

Income Tax Expense (Benefit). Income tax benefit was $15,000 during the six months ended June 30, 2018 and primarily related to the prior year-end true-up associated with our over accrual of our income tax reserve. However, income tax expense was $50,000 during the six months ended June 30, 2017 and related to state income tax expenses for which no state net operating loss carryforwards or other credits exist.

 

Potential Fluctuations in Quarterly Results and Seasonality

 

Our quarterly operating results may fluctuate significantly as a result of a variety of factors, including the following:

 

●

profitability of our restaurants, especially in new markets;

●

increases and decreases in comparable restaurant sales;

●

labor availability and wages and benefits for hourly and management personnel;

●

timing of new restaurant openings and related expenses;

●

preopening costs for our newly-opened restaurants and operating costs for those locations, which are often materially greater during the first several months of operation than thereafter;

●

timing of restaurant remodels and potential lost sales associated with remodel closure;

●

impairment of long-lived assets and any loss on restaurant closures;

●

costs related to any lease terminations, which could be significant, or fluctuations due to renegotiation of leases;

●

risks of our execution of our franchising strategy in the U.S. as well as outside the U.S. and dependence on our franchisees to successfully open and operate their restaurants;

●

fluctuations in commodity and food protein prices;

●

changes in borrowings and interest rates;

●

general economic conditions;

●

weather conditions or natural disasters;

●

timing of certain holidays;

●

changes in government regulations;

●

settlements, damages and legal costs associated with litigation;

●

new or revised regulatory requirements and accounting pronouncements; and

●

changes in consumer preferences and competitive conditions.

 

Our business is also subject to seasonal fluctuations. Historically, sales in most of our restaurants have been higher during the spring and summer months and winter holiday season. Consequently, our quarterly and annual operating results and comparable restaurant sales may fluctuate significantly as a result of seasonality and the factors discussed above. Accordingly, results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year and comparable restaurant sales for any particular future period may decrease. Operating results may fall below the expectations of our investors. In that event, the price of our common stock would likely be impacted.

 

 

Liquidity and Capital Resources

 

Our primary liquidity and capital requirements are for new restaurant construction, initiatives to improve the guest experience in our restaurants, working capital and general corporate needs. As of June 30, 2018, we had a cash and cash equivalents and short-term investment balance totaling $5.4 million that we expect to utilize, along with cash flow from operations, and the available amounts under our credit facility, to provide capital to support our business, to maintain and refurbish our existing restaurants, to invest in technology to support our restaurants, and for general corporate purposes.

 

During our high growth phase, we required significant capital resources to construct and equip each restaurant. We are slowing the pace of growth of new restaurant development in 2018, therefore, our capital requirements will be significantly less than in previous years.

 

Like many restaurant companies, we have been able to operate with negative working capital. Restaurant sales are primarily paid for in cash or by credit card, and restaurant operations do not require significant inventories or receivables. In addition, we receive trade credit for the purchase of food, beverage and supplies, therefore reducing the need for incremental working capital to support growth. Additionally, similar to many restaurant companies, we utilize operating lease arrangements for all of our restaurant locations. We believe that our operating lease arrangements provide appropriate leverage for our capital structure in a financially efficient manner.

 

Future Capital Requirements

 

As previously mentioned, our capital requirements, including development costs related to the opening of new restaurants, have historically been significant. Over the past two years, we funded development of new restaurants and maintenance capital expenditure primarily from borrowings under our credit facility and cash flows from operations. Our future cash requirements and the adequacy of available funds will depend on many factors, including the operating performance of our current restaurants, the pace of expansion and remodels, real estate markets, site locations, the nature of the arrangements negotiated with landlords and capital market accessibility and availability under our credit line.

 

We opened one restaurant at the Scottsdale Quarter in 2017 compared to eight restaurants in 2016 and seven restaurants in 2015. Our current plans for growth of the Kona Grill brand are through the franchising of restaurants both within and outside of the United States, which requires significantly less capital investment than developing new Company-owned units. We are focused on building sales, improving margins and generating cash flow to repay debt. We have significantly reduced capital spending from $8.8 million for the six months ended June 30, 2017 compared to $0.7 million in capital expenditures during the six months ended June 30, 2018. We expect to spend significantly less in capital expenditures throughout 2018, as we have slowed down our growth of new units.

 

On May 4, 2018, the Company issued to a single investor (the “Investor”) 2,651,261 shares of the Company’s Common Stock at a purchase price of $1.785 per share, which was equal to the closing bid price of the Company’s common stock on the date of the securities purchase agreement plus a five percent (5%) premium (the “Premium Purchase Price”). Following the private placement, the Investor beneficially owns approximately 19.9% of the Company’s common stock. Additionally, Berke Bakay, the Company’s Executive Chairman of the Board of Directors, acquired 492,997 shares of the Company’s common stock in the private placement at the Premium Purchase Price such that Mr. Bakay retained his current beneficial ownership of 15.7% following the private placement. Total net proceeds from the private placement were $5.5 million.

 

As of June 30, 2018, we had a working capital deficit of $4.3 million and outstanding borrowings under our credit facility of $33.7 million. As of June 30, 2018, net availability under the credit facility was $2.2 million, subject to compliance with certain covenants. We believe existing cash and cash equivalents and short-term investments of $5.4 million, the availability on our credit facility, and cash flow generated from operations will be sufficient to fund working capital and other cash requirements over the next 12 months.

 

 

Any reduction of our cash flow from operations or an inability to draw on our credit facility may cause us to take appropriate measures to generate cash. Our failure to raise capital when needed could impact our financial condition and results of operations and ability to continue as a going concern. Additional equity financing, to the extent available, would result in dilution to current stockholders and additional debt financing, if available, may involve significant cash payment obligations or financial covenants and ratios that may restrict our ability to operate our business and remain a going concern.

 

Debt and Credit Agreements

 

On March 9, 2018, we entered into Amendment No. 4 to the Second Amended and Restated Credit Agreement (“Amendment No. 4”). Amendment No. 4 amends the Second Amended Credit Agreement to, among other things, reduces the available credit on the Revolver to $25 million as of the effective date of Amendment No. 4 and further reduces the available credit on the Revolver to $22.5 million at June 30, 2018 and $20 million at December 31, 2018. Thus, requiring the Company to make payments on the Revolver of $1.25 million by June 30, 2018 and an additional payment of $2.5 million by December 31, 2018. Additionally, (a) the maturity date was amended from October 12, 2019 to January 13, 2020 with no option to extend the maturity; (b) the applicable margins for base rate loans and the applicable margins for LIBOR rate loans were increased by 50 bps to 100 bps depending on the Company’s leverage ratio; and (c) the maximum leverage ratio was increased and the minimum fixed charge coverage ratio was decreased to provide increased flexibility as further described below.

 

Amendment No. 4 requires us to comply with certain covenants on a quarterly basis, including (a) a minimum fixed charge coverage ratio of (i) 1.10 to 1.00 for the fiscal quarters ending March 31, 2018, June 30, 2018 and September 30, 2018; (ii) 1.15 to 1.00 for the fiscal quarters ending December 31, 2018 and March 31, 2019 and (iii) 1.20 to 1.00 for the fiscal quarter ending June 30, 2019 and each fiscal quarter thereafter; and (b) a maximum leverage ratio of (i) 6.25 to 1.00 for the fiscal quarter ending March 31, 2018; (ii) 6.00 to 1.00 for the fiscal quarter ending June 30, 3018; (iii) 5.50 to 1.00 for the fiscal quarter ending September 30, 2018; (iv) 5.00 to 1.00 for the fiscal quarters ending December 31, 2018, March 31, 2019 and June 30, 2019; and (v) 4.25 for the fiscal quarter ending September 30, 2019 and each fiscal quarter thereafter. The Company was in compliance with the fixed charge coverage ratio and the leverage ratio at June 30, 2018.

 

We utilized $3.75 million in proceeds from the May 2018 private placement to pay down the Revolver and permanently reduced the availability on the Revolver to $22.2 million as of June 30, 2018. At June 30, 2018, we had $33.7 million in outstanding borrowings, consisting of $20.0 million under the Revolver and $13.7 million under the Term Loan. As of June 30, 2018, net availability under the credit facility was $2.2 million, subject to compliance with certain covenants.

 

Cash Flows

 

The following table summarizes our primary sources and uses of cash during the periods presented (in thousands).

 

		Six Months Ended June 30,
		2018				2017
Net cash provided by (used in):
Operating activities		$	(218	)		$	1,064
Investing activities			(681	)			(8,841	)
Financing activities			1,192				6,894
Net change in cash and cash equivalents		$	293			$	(883	)

 

 

Operating Activities. Our cash flows from operating activities used $0.2 million and provided $1.1 million of net cash during the first six months of 2018 and 2017, respectively. The year over year change in cash from operating activities is primarily due to, timing of payments for accounts payable and accrued expenses and receipt of tenant allowance reimbursements during the first half of 2018.

 

Investing Activities.  Capital expenditures for the first half of 2018 were $0.7 million, primarily associated with remodel and maintenance-related capital expenditures. Capital expenditures for the first half of 2017 were $8.8 million, primarily associated with our Scottsdale Quarter restaurant, which opened in June 2017, remaining capital expenditures for restaurants opened during the fourth quarter of 2016, and maintenance capital expenditures.

 

Financing Activities. Financing cash inflow decreased $5.7 million year over year. Financing cash flow for the six months ended June 30, 2018 consisted primarily of $5.5 million in net proceeds received from the issuance of common stock associated with our equity offering in May 2018, partially offset by $4.1 million in payments under our credit facility (including $3.75 million from the net proceeds of the equity offering) and $0.2 million for costs associated with the credit facilities amendment No. 4. Net cash provided by financing activities during the six months ended June 30, 2017 was $6.9 million and consisted primarily of $12.5 million of borrowings and $0.2 million of proceeds from stock option exercises, partially offset by $3.6 million for the repurchase of common stock under our October 2016 stock repurchase program, $2.1 million in payments under our Credit Facility and $0.2 million for debt issuance costs associated with Amendment No.1 to our Credit Facility. 

 

Off-Balance Sheet Arrangements

 

As of June 30, 2018, we had no off-balance sheet arrangements or obligations, other than operating leases, which are not classified as debt.

 

Critical Accounting Policies and Estimates

 

Critical accounting policies and estimates are those that we believe are both significant and that require us to make difficult, subjective or complex judgments, often because we need to estimate the effect of inherently uncertain matters. We base our estimates and judgments on historical experience and various other factors that we believe to be appropriate under the circumstances. Actual results may differ from these estimates, and we might obtain different estimates if we used different assumptions or conditions. Our critical accounting policies and estimates are identified and described in our annual report on Form 10-K for the year ended December 31, 2017.

 

We had no significant changes in our critical accounting policies and estimates since our last annual report, except for the added disclosure to the revenue recognition policy as a result of the adoption of the new revenue recognition standard Topic 606. The updated revenue recognition accounting policy is as follows:

 

Revenue Recognition

 

Revenues from food, beverage, and alcohol sales are recognized when payment is tendered at the point of sale. Restaurant sales are recorded net of promotions, discounts and sales taxes. The sales tax obligation is included in “Accrued expenses” on the unaudited Condensed Consolidated Balance Sheets until the taxes are remitted to the appropriate taxing authority. We sell gift cards to our customers in our restaurants and through selected third parties. The gift cards sold to customers have no stated expiration dates and are subject to actual and/or potential escheatment rights. We recognize revenue from gift cards when: (i) the gift card is redeemed by the customer; or (ii) we determine the likelihood of the gift card being redeemed by the customer is remote (gift card breakage) and there is not a legal obligation to remit the unredeemed gift cards to the relevant jurisdiction.  As the unused balances of our gift cards are subject to the escheat or unclaimed property law, we recognize gift card breakage income upon escheatment. Gift card breakage income is recorded in “Revenue” on the unaudited Condensed Consolidated Statements of Operations and amounted to $36,000 and $200,000 during the six months ended June 30, 2018 and 2017, respectively. Prior to redemption, the outstanding balances of all gift cards are included in “Accrued expenses” in the accompanying unaudited Condensed Consolidated Balance Sheets.

 

 

We execute franchise agreements for units owned and operated by third parties. Our franchise agreements typically provide for upfront payment of territory and initial franchise fees in addition to subsequent royalty and advertising fees. Royalties and advertising fees are based on a percentage of gross sales at franchise restaurants and are recognized when earned and collectability is reasonably assured. We recognize upfront territory and franchise fees received from a franchisee as revenue when the separate and distinct performance obligations associated with the fees are satisfied. We currently believe that the services we provide related to upfront fees we receive from franchisees such as territory or initial franchise fees do not contain separate and distinct performance obligations from the franchise right and thus those upfront fees are recognized as revenue on a straight-line basis over the term of each respective franchise agreement upon store opening.  Upfront territory fees paid by franchisees in connection with development agreements are deferred when the development agreement includes a minimum number of restaurants to be opened by the franchisee. The deferred amounts are recognized on a pro rata basis as the franchisee opens each respective restaurant. Any such unamortized portion of fees received are presented in “Deferred rent and other long-term liabilities” in our unaudited Condensed Consolidated Balance Sheets. The unamortized portion of fees received totaled $0.6 million and $0.9 million as of June 30, 2018 and December 31, 2017, respectively.  Additionally, we capitalize certain costs to obtain or fulfill a contract that represent incremental costs that can be tied directly to obtaining and executing a contract. We amortize these costs over the life of the customer relationship. Costs to obtain a contract are less than $0.1 million as of June 30, 2018 and zero as of December 31, 2017 and are presented in “Other assets” in our unaudited Condensed Consolidated Balance Sheets.

 

Upon adoption of the new revenue recognition standard, we reversed $0.3 million of franchise revenue previously recorded associated with the upfront territory and franchise related fees as a cumulative adjustment to “Accumulated deficit” effective January 1, 2018. This cumulative adjustment increased our deferred revenue balance by $0.3 million and is recorded in “Deferred rent and other long-term liabilities” on the accompanying unaudited Condensed Consolidated Balance Sheet as of June 30, 2018. In addition to the changes presented above, we have historically recognized sales commissions as a component of general and administrative expenses as they are incurred. Under the new standard, certain sales commissions will be capitalized and amortized to general and administrative expense over the expected life of the customer relationship. We recognized less than a $0.1 million cumulative effect adjustment to “Accumulated deficit” with an increase to “Other assets” as of January 1, 2018.

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

Commodity Price Risk

 

Our primary market risk exposure is commodity costs. Many of the food products purchased by us can be subject to volatility due to changes in weather, production, availability, seasonality, international demand, and other factors outside our control. Substantially all of our food and supplies are available from several sources, which help to diversify our overall commodity cost risk. We also believe that we have the ability to increase certain menu prices in response to food commodity price increases.  

 

Inflation

 

The primary inflationary factors affecting our operations are food, labor costs, energy costs and labor and materials used in the construction and maintenance of our restaurants. Increases in minimum wages directly affect our labor costs. Many of our leases require us to pay taxes, maintenance, repairs, insurance, and utilities, all of which are generally subject to inflationary adjustments. These increases could impact our operating results to the extent that such increases cannot be passed along through higher menu prices. Over the past two years, inflation has not significantly affected our operating results.

 

 

Interest Rate Risk

 

We also face market risk exposure due to the variable interest rates on our credit facility. Interest on both the term and revolver loans are subject to adjustment based on changes to the Prime or LIBOR rates. Interest rate fluctuations may adversely impact our financial condition or results of operations.

 

Item 4.  Controls and Procedures

 

We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

 

As of June 30, 2018, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

 

There were no changes during the three months ended June 30, 2018 in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

 

PART II - OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

We are engaged in various legal actions, which arise in the ordinary course of our business. Although there can be no assurance as to the ultimate disposition of these matters, it is the opinion of our management, based upon the information available at this time, that the expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on the results of operations or financial condition of our Company.

 

On July 27, 2017, the Company received a letter from an attorney purporting to represent two stockholders of the Company. The letter relates to a proposal to amend the Company’s 2012 Stock Award Plan (the “Plan”) that was brought before the Company’s shareholders at its 2015 annual stockholders’ meeting. The letter claims that although the Plan amendment received affirmative votes from stockholders holding 57.7% of the shares present and entitled to vote on the proposal, it was not duly approved by the appropriate voting standard. The Company investigated the claims made in the letter and determined that the Plan amendment did not receive sufficient votes to adopt the amendment in accordance with the Company’s bylaws. The Company has determined which stock options granted by the Company since April 2015 were not within the number of shares reserved under the Plan prior to the 2015 amendment (the “Excess Stock Options”). All of the Excess Stock Options were issued in 2016 and 2017 to an aggregate of 13 employees and directors at exercise prices of $14.26 and $8.15 per share, far in excess of the current trading price. The Company also determined that none of the Excess Stock Options have been exercised. The Company entered into amendments with each of the 11 holders of Excess Stock Options who are still employees or directors of the Company. The amendments specify that such Excess Stock Options cannot be exercised until further stockholder approval is obtained for an amendment to the Plan that increases the authorized shares. Therefore, the Company believes it has taken appropriate corrective action. On April 12, 2018, the Company received a letter from Nasdaq regarding this matter. The letter stated that, although the Company violated the Rule as a result of the excess option grants, the Company has regained compliance with the Rule due to having procured the amendments from such option holders. The letter confirmed that, subject to certain disclosure requirements, the matter is now closed. At the May 8, 2018 Annual Meeting of Stockholders, the Plan amendment received a sufficient vote from stockholders to approve the Plan amendment. In July 2018, we entered into a confidential settlement agreement and the matter is now resolved.

 

 

Also, on July 27, 2017, a class action complaint was filed against Kona Sushi, Inc., a wholly-owned subsidiary of the Company, by Mitchell Boots, individually and on behalf of a Proposed Rule 23 Class, in the United States District Court for Minnesota claiming, among other things, that the Company violated Minnesota gratuity/tip pooling laws with respect to certain classes of restaurant employees. The plaintiff has brought claims on behalf of a putative Minnesota class and a putative national class of employees. On October 25, 2017, the plaintiff amended the complaint to withdraw the national class claims and other common law claims, leaving one claim on behalf of a putative Minnesota class, and added a second named Plaintiff, Tracy Fortman.  On June 15, 2018, a revised pre-trial scheduling order was issued by the District Court, setting pre-trial dates and setting a trial date of April 1, 2019.  The parties participated in mediation on August 3, 2018, which concluded without resolution. Therefore, the matter will proceed in accordance with the court-scheduled dates. The Company does not expect the result of such complaint to have a material adverse effect on the Company. However, there is no assurance that any adverse ruling or settlement in this matter would not have a material impact on the Company’s cash position and operations.

 

On November 29, 2017, Continental Atrium Corporation filed a complaint for damages in the Superior Court for the State of California for the County of Los Angeles alleging, among other things, that the Company breached its written contract relating to the Company’s decision in April 2017 to not move forward with the construction of a restaurant as discussed in Note 11 above (the “Complaint”). The Complaint alleges that beginning no later than August 15, 2017, the Company failed to pay rent and other amounts owed to the plaintiff. In May 2018, the Company entered into a settlement agreement for $0.6 million and made an initial payment of $0.5 million during the second quarter of 2018 with the remaining payment of $0.1 million due within one year from the settlement date. As of June 30, 2018, we had $0.1 million in lease termination and exit costs recorded in “Accrued expenses in the accompanying unaudited Condensed Consolidated Balance Sheets associated with this matter. On June 11, 2018, a notice of entry of dismissal with prejudice was filed and this matter is now closed.

 

Item 1A. Risk Factors

 

Other than the additional risk described below, there have been no material changes in our risk factors since our annual report on Form 10-K for the year ended December 31, 2017. A description of the risk factors associated with our business is contained in Part I, Item 1A, “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2017. These cautionary statements are to be used as a reference in connection with any forward-looking statements. The factors, risks, and uncertainties identified in these cautionary statements are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the SEC.

 

The following risk factor is in addition to those set forth in the 2017 Form 10-K:

 

If we fail to properly execute our franchise program, it may have a negative impact on our financial results.

 

Our current business strategy is to utilize franchised restaurants for expansion of our business in the U.S. as well as outside the U.S. Our ability to execute on this strategy will depend on various factors, including our ability to attract and retain franchisees of adequate quality, the identification of suitable new locations and negotiation of acceptable leases or purchase terms, regulatory compliance, ability to meet construction schedules, the financial and other capabilities of our franchisees and our ability to manage this anticipated expansion. Many of these factors are beyond our control or that of our franchisees, and there is no assurance that we can successfully carry out our franchising strategy. Our growth and success also depend upon the ability of our franchisees to successfully open their restaurants and operate these restaurants to our standards and promote the Kona Grill brand. Although we will impose operating standards on our franchisees, each franchisee will operate its restaurant independently. We cannot assure you that our franchisees will be able to successfully operate Kona Grill restaurants consistent with our standards, which could reduce their sales and our franchise royalties, and could adversely affect our financial results and our ability to leverage the Kona Grill brand.

 

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

 

Issuer Purchase of Equity Securities

 

In May 2018, the Company issued to a single investor (the “Investor”) 2,651,261 shares of the Company’s Common Stock at a purchase price of $1.785 per share, which was equal to the closing bid price of the Company’s common stock on the date of the securities purchase agreement plus a five percent (5%) premium (the “Premium Purchase Price”). Following the private placement, the Investor beneficially owns approximately 19.9% of the Company’s common stock. Additionally, Berke Bakay, the Company’s Executive Chairman of the Board of Directors, acquired 492,997 shares of the Company’s common stock in the private placement at the Premium Purchase Price. Total net proceeds from the private placement were $5.5 million.

 

Item 3.  Defaults Upon Senior Securities

 

Not applicable.

 

Item 4.  Mine Safety Disclosures

 

Not applicable.

 

Item 5.  Other Information

 

Not applicable.

 

 

Item 6.  Exhibits

 

Exhibit Number	Exhibit
31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
32.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101	Interactive data files pursuant to Rule 405 of Regulation S-T (i) the Condensed Consolidated Balance Sheets as of June 30, 2018 and December 31, 2017, (ii) the Unaudited Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2018 and 2017, (iii) the Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2018 and 2017 and (iv) the Notes to the Unaudited Condensed Consolidated Financial Statements.

_____________

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

	Kona Grill, Inc.
	/s/ James Kuhn
	James Kuhn President and Chief Executive Officer  (Principal Executive Officer)
	/s/ Christi Hing
	Christi Hing Chief Financial Officer (Principal Accounting and Financial Officer)

 

Date: August 9, 2018

 

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